1. Debt Ratios: Introduction
  2. Debt Ratios: Overview Of Debt
  3. Debt Ratios: The Debt Ratio
  4. Debt Ratios: Debt-Equity Ratio
  5. Debt Ratios: Capitalization Ratio
  6. Debt Ratios: Interest Coverage Ratio
  7. Debt Ratios: Cash Flow To Debt Ratio

By Richard Loth (Contact | Biography)

Before discussing the various financial debt ratios, we need to clear up the terminology used with "debt" as this concept relates to financial statement presentations. In addition, the debt-related topics of "funded debt" and credit ratings are discussed below.

There are two types of liabilities - operational and debt. The former includes balance sheet accounts, such as accounts payable, accrued expenses, taxes payable, pension obligations, etc. The latter includes notes payable and other short-term borrowings, the current portion of long-term borrowings, and long-term borrowings. Often times, in investment literature, "debt" is used synonymously with total liabilities. In other instances, it only refers to a company's indebtedness.

The debt ratios that are explained herein are those that are most commonly used. However, what companies, financial analysts and investment research services use as components to calculate these ratios is far from standardized. In the definition paragraph for each ratio, no matter how the ratio is titled, we will clearly indicate what type of debt is being used in our measurements.

Getting the Terms Straight
In general, debt analysis can be broken down into three categories, or interpretations: liberal, moderate and conservative. Since we will use this language in our commentary paragraphs, it's worthwhile explaining how these interpretations of debt apply.

  • Liberal - This approach tends to minimize the amount of debt. It includes only long-term debt as it is recorded in the balance sheet under non-current liabilities.
  • Moderate - This approach includes current borrowings (notes payable) and the current portion of long-term debt, which appear in the balance sheet's current liabilities; and, of course, the long-term debt recorded in non-current liabilities previously mentioned. In addition, redeemable preferred stock, because of its debt-like quality, is considered to be debt. Lastly, as general rule, two-thirds (roughly one-third goes to interest expense) of the outstanding balance of operating leases, which do not appear in the balance sheet, are considered debt principal. The relevant figure will be found in the notes to financial statements and identified as "future minimum lease payments required under operating leases that have initial or remaining non-cancel-able lease terms in excess of one year."
  • Conservative - This approach includes all the items used in the moderate interpretation of debt, as well as such non-current operational liabilities such as deferred taxes, pension liabilities and other post-retirement employee benefits.
Note: New accounting standards, which are currently under active consideration in the U.S. by the Financial Accounting Standards Board (FASB) and internationally by the International Accounting Standards Board (IASB), will eventually put the debt principal of operating leases and unfunded pension liabilities in the balance sheet as debt liabilities. Formal "Discussion Papers" on these issues are planned by FASB and IASB in 2008, with adoption of the changes following the discussion phase expected in 2009.
Investors may want to look to the middle ground when deciding what to include in a company's debt position. With the exception of unfunded pension liabilities, a company's non-current operational liabilities represent obligations that will be around, at one level or another, forever - at least until the company ceases to be a going concern and is liquidated.

Also, unlike debt, there are no fixed payments or interest expenses associated with non-current operational liabilities. In other words, it is more meaningful for investors to view a company's indebtedness and obligations through the company as a going concern, and therefore, to use the moderate approach to defining debt in their leverage calculations.

So-called "funded debt" is a term that is seldom used in financial reporting. Technically, funded debt refers to that portion of a company's debt comprised, generally, of long-term, fixed maturity, contractual borrowings. No matter how problematic a company's financial condition, holders of these obligations, typically bonds, cannot demand payment as long as the company pays the interest on its funded debt. In contrast, long-term bank debt is usually subject to acceleration clauses and/or restrictive covenants that allow a lender to call its loan, i.e., demand its immediate payment. From an investor's perspective, the greater the percentage of funded debt in the company's total debt, the better.

Lastly, credit ratings are formal risk evaluations by credit agencies - Moody's, Standard & Poor's, Duff & Phelps, and Fitch - of a company's ability to repay principal and interest on its debt obligations, principally bonds and commercial paper. Obviously, investors in both bonds and stocks follow these ratings rather closely as indicators of a company's investment quality. If the company's credit ratings are not mentioned in their financial reporting, it's easy to obtain them from the company's investor relations department.

Debt Ratios: The Debt Ratio

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